U.S. Spending Eases Q3 Worries

News that US personal consumption expenditures rose 0.8% in July should go a long way toward easing anxiety that the world;s largest economy is slipping into a new contraction.  It means that even if Aug and Sept consumption slips back to trend (~0.2%) and no other major surprises, Q3 GDP is looking no lower than 1.5%.  This of course is nothing to write home about, except in the context of the dismal survey data and recession fears.   

That said, it is possible that the rebuilding from the storms help inflate spending in Aug and Sept.  In addition, money supply growth has picked up and withholding taxes have also reportedly increased (and we know people do not pay taxes on phantom income).

Personal income rose 0.3%, but in real terms it actually slipped 0.1%.  This means that in order to fund the spending, Americans dipped into savings.  The savings measure fell from 5.5% to 5.0%.  This is obviously not sustainable in the intermediate and long term.  Consumption has to be financed by income not savings.  This underscores the importance of the US employment report at the end of the week.  The headline number is likely to be distorted by the Verizon strike, but the market will look for the strike adjusted number (add around 40-50k to the headline report).  

The fact that the core deflator ticked up to 1.6% from 1.4% in June (1.3% initially) illustrates a factor constraining the Fed's options.  One success that the Fed had was in overcoming the threat of deflation.  This preferred Fed measure is not far from the informal target (aka comfort zone).  

The survey data remains poor and this was again illustrated by the Aug Dallas Fed mfg survey.  It fell to -11.4 form -2.0 in July.  The ISM manufacturing series is to be released Thurs and a soft report is expected.  When it comes to inflation the record is clear, since at least 1980, headline inflation has converged to core.  However, no such rule is clear when it comes to the survey data and actual data.  The divergence of the two in recent weeks is clear.  What is not clear is if the survey data is a lead indicator or precursor to the real sector data.  It could be.  It could be a self-fulfilling aspect or what Soros has called reflexivity.   

The best thing, perhaps the only thing for investors to do is be patient and watch the data come in.  The take away point from today's personal income and consumption data is that the US economy is off to a good start in Q3 despite the survey data.  

Japan's Noda becomes the 6th Prime Minister in 5 years.  No significant policy change is expected.  Noda appears to be sympathetic to tax hikes and does not seem to be inclined to intervene.  Attention will turn to his choice of finance minister.  Stylistically, Noda may be more inclined to have the DPJ work with the other political parties.  

Turing to Europe there are two noteworthy developments.  First, Germany's Aug CPI eased 0.1% to bring the year-over-year rate to 2.3% from 2.4%.  The German economy stalled in Q2.  It had grown 1.5% quarter-over-quarter in Q1, a spectacular showing.  Every one understood that it was not sustainable, but the 0.1% growth in Q2 was a total surprise.  Moreover, there are some--like IFO and PMI folks--who are warning about a Q3 contraction.   ECB rate hikes both in 2008 and earlier this year coincided with increased tensions  in the euro zone.  

Although I understood the ECB's logic in raising rates, not once but twice this year, I thought the move was a mistake.  Yet the talk that has begun creeping in of it reversing a hike seems premature.  Draghi is set to take over later in the year.  In order to reinforce his anti-inflation credentials, there was some thought that he could deliver a Q4 hike.  While the justification for this is fading, he may not be able to cut rates in his first couple of meetings without strong unequivocal economic crisis.  

Separately, the ECB indicated that it has dramatically reduced its bond buying in the most recent week to 6.65 bln euros, down from 14.28 bln the previous week and 22 bln the first week.   The news would suggest that the ECB is content with the push in 10-year yields to around 5%.   Trichet's claim at Jackson Hole that ECB bond buying has been less than the Fed or BOE is factually true, but it sidesteps a key issue.  It is not simply size buy quality that seems to be important.  

The ECB is buying bonds that the private sector wants to sell.  They are are not of AAA quality.  The Fed has bought Treasuries and is gradually reducing its MBS portfolio.  The BOJ is buying ETFs and REITs and corporate bonds.  It has argued in the past that its asset purchases on a rsik adjusted basis are larger than the notional amount.  Surely the same case ought to be made about the ECB.  

Italy's new 10-year bond auction tomorrow comes as the ECB is scaling back its purchases and as the political situation deteriorates in Italy.  Even if Berlusconi were to exit the political stage, which does not appear imminent, it is not clear that the opposition have a clear alternative in anything but personalities.  That may be fine for as far as it goes, which is not that far.  France and Spain also have bond auction this week and  while the auctions most likely will not fail, a warm reception is equally unlikely.  

The strong(er) US economic data did not do the greenback many favors.  Turnover in the FX market on Monday was restrained by the holidays in parts of Asia, the UK and the storm recovery on the US east coast.  Of note the Swiss franc has continued to weaken against the euro and the next target is near CHF1.20 for the euro.  Also, perhaps less obvious to some, the dramatic unwinding of gold positions may also be impacting the currency markets, though many pundits often see the relationship the other way around.